The Federal Reserve meets next week and markets are pricing in 100% probability that the U.S. central bank moves to lower borrowing costs. Such a move would benefit an array of fixed income segments and the related exchange traded funds, including emerging markets bonds and the VanEck Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC).
EMLC seeks to replicate the price and yield performance of the J.P. Morgan GBI-EM Global Core Index. The index is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer.
“In our view, the shift in policy globally is creating a potential runway for emerging markets currencies (EMFX) to possibly fare better versus the U.S. dollar, and for emerging markets central banks to, partly as a consequence, take a more dovish stance with regard to their own interest rate policies,” said VanEck in a recent note.
Emerging markets bonds, particularly those denominated in local currencies, are often levered to Fed action because lower U.S. rates can depress the dollar, thereby bolstering emerging markets currencies and assets denominated in those currencies.
Evaluating EMLC ETF
The $5.4 billion EMLC holds 278 bonds and has a 30-day SEC yield of 6.34%. EMLC’s modified duration is 5.26 years.
As opposed to emerging markets equities that primarily concentrate on China, EMLC also gives investors exposure to other corners of the bond market for diversification. This can help ease any pain should a stronger dollar continue since EMLC’s holdings are less correlated to the greenback.
“We believe that market expectations for lower rates are based on a view of central banks’ willingness to be extremely cautious about protecting growth and asset prices, and are not reflective of an impending end to the economic or credit cycle,” according to VanEck. “If correct, this would be bullish for most asset classes and favor taking on more risk within fixed income portfolios. In this scenario, we believe emerging markets local currency bonds would fare particularly well.”
Of course, it would be helpful if emerging markets central banks cut rates, too. Among EMLC’s largest geographic weights, Brazil (9.9% weight) is a credible rate cut candidate.
“Many emerging markets central banks would have room to cut rates, potentially boosting local interest rate driven returns which have already provided the bulk of total return this year, while a weaker U.S. dollar could provide some lift to relatively stagnant EMFX returns,” notes VanEck.
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